In the language of construction and construction finance, there are many documents, agreements, provisions, and other terms. Some terms have different meanings depending on who you speak to, while others have meanings that overlap. This construction payment terms explanation will break down the confusing set of phrases into an easy-to-understand nomenclature.
When a general contractor strikes out on their own, they have the freedom to create their own business model. They can choose the projects they want, hire who they want, and set their own payment terms. Even the most common contractor payment terms may make you feel uncomfortable if you’re an owner or a subcontractor.
At first glance, it may seem that a general contractor is trying to take advantage of their customers or subcontractors by establishing their payment terms in this way. Let’s look at some of the most common contractor payment terms so you can make an informed decision about who you want to work with.
Who sets contractor payment terms?
A construction contract’s payment terms are determined by an agreement between a contractor and a subcontractor. When they negotiate the contract, they both set the terms. Any part of the contract can be negotiated — pay schedules, pricing, discounts — the idea is that the parties will come to an agreement that benefits both parties.
An owner will hire a general contractor to oversee the entire construction project. The general contractor could be a single person or a large general contracting firm. The general contractor will subsequently hire subcontractors to complete various aspects of the project. Subcontractors frequently employ their own subcontractors, and such, until the project is finished.
Then, at each level, owners, general contractors, and subcontractors negotiate their own contracts. The owner negotiates with the general contractor. The general contractor negotiates with their subcontractors. Subcontractors negotiate with their subcontractors. It’s a long chain of payment term negotiations.
Down payments and deposits
In some cases, general contractors will negotiate or require a down payment or upfront deposit from the homeowner on residential projects. This upfront payment covers the costs of materials and initial labor. Doing as such is a common, everyday occurrence that is entirely legal.
Property owners typically do not want to pay a deposit, preferring to rely on the contractor to cover the upfront costs. However, this may not be an option for all contractors; some have a deposit amount or percentage as part of their policy. Others may be more willing to discuss alternative options.
Deposits can range from 10% on large, multi-stage projects up to 50% on smaller jobs. On medium-sized projects, a reasonable expectation is between 25 and 33%. Anything more than 50% is unreasonable, regardless of the type of project.
Subcontractors typically do not receive deposits from general contractors, except in very rare cases. Subcontractors must use their own capital to fund their part of the project, including manpower and materials, and they frequently do not make a profit until the project is completed.
Cash flow protection by contractors
Higher-tier contractors will frequently try to hedge their bets and protect their cash flow by including pay-when-paid clauses in their contracts. These clauses state that the subcontractors on the project will only be paid after the owner has paid the general contractor. This way, the general contractor isn’t out of any money before receiving their own payment from the owner.
Pay-when-paid clauses are legal, but they aren’t always enforceable. Because these clauses are legal, states can use them to pass laws stating how long the general contractor and subcontractors must pay their subcontractors after receiving payment.
To ensure that subcontractors complete their tasks, general contractors will hold back a part of their payments until the end of the project. This amount, commonly known as retainage, is typically around 10% of each payment. While this is a legal and common practice in the industry, it also secures the general contractor’s cash flow.
Common Contract Payment terms in construction
So, what can subcontractors expect when it comes time to cut the checks? How long does an owner have to pay an invoice? What is a reasonable timeframe for a subcontractor to expect to wait for payment?
- Lenient terms
Three-quarters of all construction companies do not offer any kind of early payment discount. Imagine how much interest a company could save if all of their customers paid early. Talk about a win-win situation.
As a homeowner, a relaxed payment schedule may appear to be a blessing — but someone must pay the price (literally). Pay-when-paid clauses, coupled with a lenient payment policy, mean that subcontractors may be out of cash for months at a time on the work they finished. You may think that this is not a problem for you, but it could be in the future.
- Payment terms in small projects
When it comes to smaller projects, it is common for contractors to request higher upfront percentages than they would on larger projects. This upfront percentage will frequently cover all of the materials as well as a portion of the labor. To get the project off the ground, expect to pay 10–50% upfront.
Following the initial deposit, the next payment is usually made at the end of the project.
Let’s use a project ABC as an example:
The contractor and owner come to an agreed-upon price of $10,000. The owner can expect to pay the contractor $5,000 at the beginning of the project. So then, the remaining $5,000 is due when the contractor completes the project.
Once the project is finished, the contractor submits a bill for $5,000. For smaller jobs, the owner is generally expected to pay the invoice upon receipt or shortly after that.
- Payment terms on medium projects
Contractors frequently structure payment terms for medium-sized projects in the same way they do for smaller jobs — with a few minor changes.
Contractors complete medium-sized projects, such as those lasting a few months, in stages. As a result, deposits are typically smaller, and payment dates are scheduled throughout. The initial deposit kickstarts the project, while scheduled payments keep it moving ahead.
For example, let’s look at a $100,000 project that will take three months to complete. In this case, the contractor may require 25% upfront, 30% after month one, 30% after month two, and the remaining 15% when the project wraps up.
The contractor should submit an invoice with the amount due and the due date at each payment stage. As previously stated, it is not uncommon for contractors to give property owners more than 30 days to pay.
- Payment terms on large projects
Large residential projects, such as homebuilding, frequently necessitate even lower deposit percentages. In these cases, the general contractor may require a 10% down payment and then set up draws or progress payments for the project’s life. The general contractor will then pay their subcontractors from these draws.
However, this scheme does not apply to commercial projects. General contractors rarely receive deposits on commercial contracts. They will instead have to float the job using their cash or credit accounts. At the same time, their subcontractors will be required to float their portion of the project, and so on.
Progress payments are the norm on these projects. They are related to the project’s progress or the value schedule. Each month, subcontractors will be required to submit payment applications. If the general contractor negotiated pay-when-paid clauses into the subcontractor’s contracts, those subcontractors must also wait.
If you thought the 30-day timeframe for residential payments was long, wait until you see the timeframe for commercial projects. Subcontractors can expect to wait an average of 80 days for payout on these invoices.
In commercial projects, retention is also an important factor. Not only do most subcontractors have to wait until the general contractor is paid, but they also have to wait until the end of the project (long after their portion is completed) to recover the remaining amount of owed cash. That bit of retainage is frequently far larger than their profit margin, which means they’re in the red until the final checks are passed down the chain.
JCT Contract Payment Terms in Construction Projects
With so many different agreements and project types in the construction industry, the standard form JCT Contract includes multiple supply chain payment options, which are detailed below:
- Advance Payment
A lump-sum payment is made prior to the start of any work to aid in the product’s cash flow provide security for the contractor. Typically, this is an amount equal to the peak cash flow. Any advance payments will almost certainly be secured by a bond, which will provide the employer with security in the event of contractor default.
- Interm Payments
These are the most common types of payment mechanisms in the industry. They require the Contractor Administrator (CA) to send a payment notice no later than five calendar days after the payment is due. Payment is usually due 7 days after the interim valuation date. The final payment date is usually 14 days after the due date.
- Pay Less Notices
Following the issuance of a Payment Notice by the Contract Administrator or Employers Agent (EA), the employer is obligated under the contract to pay the money due within the prescribed timeframe (+14 days from the due date). However, if an employer wishes to pay less than the amount specified in the payment notice, a pay less notice must be issued no later than within 5 working days.
- Final Payment / Final certificate
This will be issued no later than two months after the last of the following events;
- The expiration of the rectification period.
- The date of the issue of making good defects certificate.
The final certificate will state the contract sum as adjusted throughout the contract, as well as the sum of amounts previously stated as due (the previous cumulative payment).
What happens when payment terms aren’t met?
Even for small projects, it can take a long time to get paid. The mechanics lien is a tool that states, give for contractors and subcontractors to use to speed up the payment processing.
If project owners or general contractors fail to meet payment deadlines, the other contractors in the payment chain have the right to file a mechanics lien against the property. In the event of a successful foreclosure suit, a mechanics lien can make it difficult for the owner to obtain additional financing, making the property more difficult to sell, or forcing the property to go up for auction.
Even if the general contractor is paid on time, if the subcontractors aren’t paid, they can file a lien.
To avoid issues with subcontractors filing liens, project owners must ensure that their general contractor adheres to the payment terms that they agreed to.
Standard payment schedule for the contractor
Having a set schedule can help to reduce the likelihood of issues, but it is only one part of the equation. Let’s look at the issues and different options for effective general contractor payment schedules.
Every aspect of a construction project appears to be the “most important part” of the job in some way. The fact is that there can be no project without payments and cash changing hands. In this regard, payment schedules may be the most important factor in ensuring that a process runs smoothly. Your payment schedule may be influenced by the type of contract you’re using. Payments made under a time and materials contract are frequently more flexible than payments made depending on the project’s progress or defined timeframes.